It can be certainly argued that no debt is good debt. But borrowing money and taking on debt is the only way by which many households afford to make large purchases like houses, cars, jewellery. Do all these debts add value? Juggled with the decision- whether the debt taken is good or not? Today we are going to answer these questions for you.
Understanding the key difference between good debt and bad debt is essential to make correct financial decisions. In this article we will talk about what are good debts and give some examples of them. We will also see what are bad debts, types of bad debts, bad debt examples and find differences between good debt vs bad debt.
Good debts are low interest investments that grow in value over time and have the potential to earn you recurring income in the future. There is an old saying,”It takes money to earn money”. Investing in good debts can improve your lifestyle since often the benefits of borrowing exceed the interest cost. Let's see some of the things which are often worth investing:
Good debt examples
1. Education loan:
Taking student loans while you are studying is considered a good debt because education increases your value and can fetch you a job after you graduate. Also, the loan carries a comparatively low interest rate (starts from 7% above) and the interests paid are tax deductible.
2. Mortgages and real estate investments:
House mortgages (typically ranges between 8%-11%) are considered good debts because they give you a permanent place to live in, interests paid are tax deductible, and typically house prices rise over time.Home equity loans or Home equity lines of credit are similar forms of investment. Investing in other forms of real estate like lands, factories, are also good debts since their prices increase over time and can help to grow your business.
3. Business Loans:
Loans taken for expanding your business can be a good debt as long as you have a realistic business plan and you are sure that you can pay the monthly repayments.
Bad debts are investments on assets that lose their value (or depreciate) over time and cannot return income in the future. Bad debts often carry high interest rates and hence cost of borrowing exceeds the benefits. There are many types of bad debts. But let’s see the common ones, from the perspective of the loan borrower.
Bad debt examples
1. Payday loans:
These are the short term loans, often repayment is in days or in a month, taken as a last resort. They are the worst debts of all loans because they have the highest interest rates of all the loans, which can start from 36% and can go upto 365% annually, hence should always be avoided.
2. Credit card debts:
Credit cards used for buying unwanted consumables like expensive clothes, electronic gadgets, concert tickets and expensive holidays are bad debts because these items lose their value after use. Additionally, interest on credit card debts (APR) are very high, around 3% per month or 40% annually (excluding the hidden costs). Click to read more on credit card disadvantages.
3. Loan Shark deals:
Instant loan apps or the lenders you know through your network, offering short term loans without any background check, charges very high interest rates and should be avoided at all cost.
4. Loans to invest in stock markets:
Stock markets are highly volatile, prices of stocks may be high one day and low the next day. Hence taking loans to invest in stocks is a very risky affair and is considered a bad debt.
Some loans can be both good as well as bad depending upon what purpose you use it for:
1. Car Loans :
Buying cars which you can’t afford and which you don’t use often,are bad debts since cars lose their value once they are on roads. But buying a car is a good purchase if you need to travel daily and can earn from renting it the rest of the day.
2. Personal Loans:
If you take debt to pay out your current obligations, then of course it is a bad debt as you are taking a debt on top of another debt. But personal loans can also be taken for consolidating multiple loans into one loan, and if properly managed, can be good debts.
Good debt vs bad debt - Frequently Asked Questions (FAQs)
1. What is considered to be a good debt-to income (or DTI) ratio?
DTI is the ratio between Gross monthly debt and Gross monthly income. A ratio of around 21-35% is considered a good debt to income ratio. It is used by lenders to evaluate your potential of repaying the debt. Lower DTI ratio improves your credit score and increases the chances to get your loan fast approved and sanctioned. A rule of thumb: you should not borrow more than what you can afford to pay.
2. What is the 50/20/30 budget rule?
It is the most popular and simple plan used when you are not sure where to start with a budget. It says spend 50% of your income on needs, 30% on wants and 20% on financial goals. Needs are absolute necessities like bills,food, housing, health insurance. Wants are things which are absolutely not essential like movies, dining, sports. Financial goals are money spent to pay debts and save for retirement.
3. How to get out of bad debt for good debt?
Following are the strategies you can use:
a. Know your debt well
b. Prioritize the debts in decreasing order of interests
c. Consolidate all the debts into a single one using personal loan
d. Free up some cash by eliminating unnecessary spendings like subscriptions, phone bills, restructuring health insurances
e. Make more money by joining higher salary jobs or running a side business
f. Start leveraging your good debts. Cash flow earned on good debts can help you to pay off the bad debt